Are We Witnessing a Tectonic Shift in Which Central Bank Policy Dominates Asset Prices and Risk Premiums?

Investors can't afford to ignore the consequences of massive moves in the foreign exchange market.

Friday, Jan. 18, the Federal Reserve released the transcripts from 2007 FOMC meetings that included those fateful days as they grappled with how to address the housing "correction" and developing credit crisis.

At the August 7, 2007 FOMC meeting it was clear the Fed was not all that concerned with escalating systemic risk as the agenda was full of fond farewells, jokes, laughter and bureaucratic nonsense. They concluded by debating the semantics of the statement.

Chairman Bernanke: Okay. Let me just get a sense around the table, if I could. I think President Hoenig makes the point that volatility in financial markets could be viewed as having an effect on the economy through uncertainty and those sorts of factors. One option is "financial markets have been volatile in recent weeks." The second option is "risk premiums in financial markets have increased." Who wants "volatility"? [Laughter] I see five. Who wants to make the change?

Mr. Kohn: I guess I would.

Chairman Bernanke: Oh, great. [Laughter] All right.

Mr. Mishkin: We flip a coin?

Mr. Kohn: You have the deciding vote.

Chairman Bernanke: Okay.

Mr. Lacker: One factor for me is that "volatility" is a very broad term, and "risk premiums" refers to a narrow set of markets, and this way shifts the focus off equity markets.

Chairman Bernanke: Okay. I apologize profusely for bringing this up. Why don't we just leave it? [Laughter] So after all the discussion, my proposal is to follow President Plosser and to replace paragraph 3 with the June version. Please call the roll.

Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Funny...

You may recall how the ensuing events unfolded. Former Treasury Secretary Robert Rubin called Ben Bernanke, which led to meetings with Bridgewater's Ray Dalio and former Salomon Brothers MBS market pioneer Lewis Ranieri. Then only three days later on August 10, in full-blown panic mode, an emergency conference call led to a 50bps discount rate cut. There were no jokes this time. The Fed also changed their economic assessment to downside risks to growth due to market conditions. As I wrote in Helicopter Ben Rides Again, this was an important distinction.

After two years of whistling past the housing market graveyard, the immediate policy 180 emitted a sense panic and capitulation. Bernanke would link heightened financial market risk with heightened economic growth risk to justify the abrupt change in policy. This is very important.

Once he moved on the theory that market "uncertainty" increased risk to economic growth, he set a precedent for preemptive intervention in financial markets whenever the Fed deemed it necessary to "mitigate" increase downside economic risks. This interpretation of the Fed's mandate is a defining moment in Bernanke's tenure.

The following six months of FOMC decisions would read like a horror story as it pulled its economic assessment and slashed interest rates 300bps, taking the FF rate to 2.25% by the March 2008 meeting. Bernanke's dovish reputation immediately began to manifest itself in the market. Despite the risk of slowing growth, discounts for inflation increased significantly. The dollar weakened, commodity prices soared, and the yield curve steepened. Helicopter Ben had demonstrated his inflationary bias. Once he gave the green light, it was clear the market wanted to be in front of the curve.

It is my belief that the interpretation of what caused the financial crisis has been extremely shortsighted. The consensus sees the crash as the result of the housing bust and credit crunch, but markets don't crash due to what everyone already knows, and they don't crash because of deteriorating economic fundamentals. There must be a systemic catalyst.

In 2008 the markets were actually holding together relatively well despite the failure of Bear Stearns in March. However the Fed's massive easing campaign was taking its toll on the value of the US dollar. Commodities were rallying in the face of decelerating economic growth, and with the price of oil doubling in less than 12 months, this proved debilitating to the US economy but even more so on leveraged risk premiums. The following is also taken from my article mentioned earlier:

By July, nominal GDP had flatlined. But with the dollar continuing to deteriorate and oil prices up 100% from a year ago, inflation was delivering a crushing blow to an already teetering economy. The July reading for YOY CPI was 5.6%, but the PPI came in at a whopping 9.9%. Typically the PPI does not exceed the CPI as raw material costs get passed on to the consumer -- and aside from the 1970s, it rarely occurred. This unusual 400bps inversion driven by rocketing commodity prices produced a statistical fat tail.

In fact as I point out the ratio of inflation to nominal GDP was higher than the inflation spikes in the 1970s and 1980s. This was the systemic event. Inflation premiums spiked, the yield curve blew out to historic levels and risk premiums were soon to follow.

It is my belief that dysfunction in credit markets continued to worsen not despite the easing of monetary policy but because of the easing of monetary policy. Initially, the housing and mortgage crisis was contained to those markets. It was not until the Fed opted to forego its inflation risk bias in favor of liquidity support for those markets that the crisis spread. The further the FF rate dropped below the rate of inflation, the wider the inflation discount and thus risk premiums became.

The 2008 crash didn't happen because people quit paying their mortgages. It happened because of a rapid repricing of risk premiums in highly leveraged (short volatility/short gamma) positions due to a spike in inflation discounts that drove an eventual spike in implied volatility. The correlations between the dollar, commodity prices, the yield curve, and the risk curve are undeniable.

Perhaps there is nothing more systemic than extreme volatility in foreign exchange markets. While today's headlines are focused on stocks reaching new post-crisis highs and junk bond yields reaching all-time lows, investors seem to ignore the consequences of massive moves in the foreign exchange market.